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How independent are independent directors?

Board independence is a pillar of good corporate governance. It ensures that a corporation’s management is properly monitored and that the corporation’s decisions effectively balance the various stakeholders’ interests. Over the past decades, Canadian regulators (with support from investors) have required companies to increase the number of independent directors on their boards and have created stricter requirements for what qualifies as ‘independent’. But are independent directors now truly independent?

In a US paper published by Kastiel and Nili, the authors argued that independent directors today, while technically independent, are functionally still very dependent on management. This is because of the directors’ “informational capture” – lacking the time, adequate resources, and specific knowledge to properly obtain, digest, and analyze extensive and complex information that modern boards evaluate. This informational gap often causes independent directors to rely on the information management provides, or conceals, and the way that information is provided.

The authors outline four reasons for this informational capture:

outside directors usually lack direct access to company information, and thus rely heavily on management as their source of information;

outside directors are often exposed to voluminous information, but lack the resources to properly analyze it all in a timely fashion;

while outside directors have general business skills, most of them lack relevant company or industry-specific knowledge, which often takes a few years of board membership to properly acquire; and

lack of information often facilitates other behavioural biases, such as groupthink, which then further solidifies the directors’ reliance on management for information.

The rise of super directors

To address this issue, some activist shareholders have been pushing for what the authors call “super directors”—activist-nominated directors who have the full resources, and analytic strength, of the (often institutional) investors that nominated them. Such institutional support allows super directors to collect, analyze, and edit voluminous information in a timely fashion, and share their results with the rest of the board, who now have a new source of information.

Super directors, however, are only a temporary solution to the problem. First, most companies are not targeted by activist investors, and thus don’t benefit from such directors. Even when they do, super directors are only there for a few years, and don’t leave behind any organizational knowledge for the other directors to rely on once they exit. Additionally, activist directors may be prevented from accessing some of the corporation’s information, or sharing it with their team due to conflicts of interest. Finally, those directors, like their nominating shareholders, may only have short-term plans for the company.

Board suites

For a more effective solution, the authors suggest the creation of a “board suite”—full-time special informational counsel to the board. Such counsel would request, summarize, and prepare information from management, as well as assess the completeness of the information provided. The suite would become the institutional knowledge base of the board, unaffected by the change in directors. Board suites could also take over some of the shareholder engagement tasks, particularly those who are data/information driven. Similarly, it could also help in establishing long-term relationships with key shareholders, and prevent miscommunications since, unlike directors, the suite would be a constant in the board.

The proposed board suite doesn’t come without its own problems – such as increased administrative costs and potential difficulties in its implementation – but it does highlight a serious issue that corporations and shareholders alike need to turn their minds to. If good corporate governance is actually to be achieved, management, directors, and shareholders must all work together to ensure that the independent directors are getting, and understanding, all the necessary information to properly make decisions.

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The author would like to thank Ahmed Labib, summer student, for his assistance in preparing this legal update.

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Norton Rose Fulbright's Special Situations Team has played a leading role in Canada’s most high-profile shareholder activist and defence mandates, as well as complex reorganization transactions. The Special Situations Law blog is about sharing our insights with you. With videos discussing shareholder activism, links to relevant case law and legislation and incisive commentary about regulatory and legal developments, our blog includes a wealth of resources and perspectives on special situations law.